The Investment Scientist

Irrevocable Life Insurance Trust

Posted on: June 16, 2011

[Guest post by Jeremy Bendler] Few people realize that, even though they may have a modest estate, their families may owe hundreds of thousands of dollars in estate taxes because they own a life insurance policy with a substantial death benefit. This is so because life insurance proceeds, while not subject to federal income tax, are considered part of your taxable estate and are subject to federal estate tax.

The solution to this problem is to create an irrevocable life insurance trust that will own the policy and receive the policy proceeds on your death. A properly drafted life insurance trust keeps the insurance proceeds from being taxed in your estate as well as in the estate of your surviving spouse. It also protects the trust beneficiaries from their own “excesses”, against their creditors, and in the event of divorce. Moreover, the trust also provides reliable management for the trust assets. Here’s how the irrevocable life insurance trust works.

You create an irrevocable life insurance trust to be the owner and beneficiary of one or more life insurance policies on your life. You contribute cash to the trust to be used by the trustee to make premium payments on the life insurance policies. If the trust is properly drafted, the contributions you make to the trust for premium payments will qualify for the annual gift tax exclusion, so you won’t have to pay gift tax on the contributions.

The life insurance trust typically provides that, during your lifetime, principal and income, in the trustee’s discretion, may be paid or applied to or for the benefit of your spouse and descendants. This allows indirect access to the cash surrender value of the life insurance policies owned by the trust, and permits the trust to be terminated if desired despite its being irrevocable. On your death, the trust continues for the benefit of your spouse during his or her lifetime. Your spouse is given certain beneficial interests in the trust, such as the right to income, limited invasion rights, and eligibility to receive principal. On the death of your spouse, the trust assets are paid outright to, or held in further trust for the benefit of, your descendants.

If you own a life insurance policy with a significant death benefit, an irrevocable life insurance trust may be of substantial benefit to you.

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15 Responses to "Irrevocable Life Insurance Trust"

A very good point that many people forget is that life insurance generally pays out free of income taxes but can be subject to the confiscatory estate tax if not properly owned.

It should be noted, though, that under current tax law each person gets a $5 million exemption from the estate tax (married couples $10m). So while one needs to be sure to include the face value of life insurance they own when considering estate tax liability, utilizing an ILIT is not automatically a necessity. A couple would have to have a net worth including death benefits approaching eight figures before it becomes a real tax saver, at least under current federal estate tax law.


Very good point you point out. In fact, can you comment on downside of using ILIT.


Hi Michael – I’m not sure that it’s exactly ‘downside’, but utilizing an ILIT adds a layer of complexity which results in higher costs (for things like having an attorney create the trust and having a trustee monitor it on an ongoing basis) and having to deal with issues like Crummey notices and gift tax considerations.

In the proper situation those extra costs and complexity are far outweighed by the tax savings which is why I hesitate to necessarily call them ‘downsides’; it’s just that having an ILIT really is beneficial to clients having those larger estates (and making sure we include the life insurance death benefits in calculating the estate).

And remember that the tax law (constantly, it seems!) changes, so creating an Irrevocable trust might commit a person to a strategy that a few years down the road provides little tax benefit based on new laws.

— John

It’s not just that tax law changes, personal circumstance also changes. I know a doctor has a huge ILIT and very burdensome funding liability. It sounded like a great idea when he was working and making a lot of money. Not any more now that he is retired.

All I was thinking was that is buying a life insurance could help you in the future by the time when you need it most especially if you are the breadwinner in the family. Now this article have opened my mind that , buying a life insurance – if not properly managed – might lead you in a debt without you knowing it.

Armil – it’s not that it would leave your heirs in debt, it’s that above the estate tax credit assets passed to heirs are taxed at 35%. So if your estate is right at the limit and you buy (and personally own) a $1m insurance policy and then you die, your beneficiaries would net $650k after taxes.

But another factor in this discussion is that one can pass an unlimited amount of assets to a spouse without estate tax concerns. So in the little scenario I just described, if your spouse received all of your assets he or she’d get the full $1m insurance benefit – then when she died your kids would deal with the estate tax.

I think this helps to show why it is important to get expert help when dealing with these issues – rarely is anything as simple as it may seem, and making a minor mistake can cost major money.

What happens if you buy life insurance and on the application list the beneficiary as the trust and the trust is never completed who then is the beneficiary

Sorry Mike, I have no idea why anyone would name a nonexisting trust as beneficiary. ~Michael

I’m guessing the question comes in the situation where a trust document hasn’t been completed but the person is in the process of putting everything together and gets ahead of himself (or the agent is in a hurry to get paid on a whole life policy), the insurance is applied for assuming the trust will be finished but subsequently the trust never does get completed.

You’d have to check with the company, but I believe that it would be handled in the same fashion as if a person is named as the beneficiary but no longer exists (is dead) – proceeds would go to the secondary beneficiary or if one isn’t named to the estate.

However, using an ILIT means that the trust OWNS the policy, and I don’t know how an entity that is never created could be the owner of the policy.

Can the Grantor (person insured) receive any money if the trustee decides to cash in the policy prior to the death of the grantor (insured). Suppose the grantor petitions the trust to receive money when the policy is cashed in.

Bruce, I will pass your question to the author.

The “grantor” does not own the policy and is not a beneficiary of the trust. In the example in the article distributions are allowed to the spouse, and the descendant beneficiaries, not to the “grantor”.

I understand term life insurance cannot be transferred to a ILIT, is that correct?
Also, when the estate is at the limit without including life insurance benefits, an ILIT can help but not if the insurance is term life, is that right?

I don’t believe so. You can include term life insurance in a ILIT.

An individual is elderly and no longer wishes to keep up on the premium payments on the term life policy currently owned by the ILIT he set up thirty years ago. He is also no longer married to the woman who was his wife when the ILIT was set up. He wants the policy transferred to his children, and his ex-wife is agreeable but doesn’t want a taxable event.

Assuming everyone is on board, and applicable law allows for the ILIT to be terminated upon agreement by grantor and all the beneficiaries, how should this play out? If the lawyer gets the ILIT terminated by court order, now there is a life insurance policy with no owner and no beneficiary, correct?

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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